Tag Archives: QT

Yeah…But

Yeah… Barry Bonds, a Major League Baseball (MLB) player, put up some amazing stats in his career. What sets him apart from other players is that he got better in the later years of his career, a time when most players see their production rapidly decline.

Before the age of 30, Bonds hit a home run every 5.9% of the time he was at bat. After his 30th birthday, that rate almost doubled to over 10%. From age 36 to 39, he hit an astounding .351, well above his lifetime .298 batting average. Of all Major League baseball players over the age of 35, Bonds leads in home runs, slugging percentage, runs created, extra-base hits, and home runs per at bat. We would be remiss if we neglected to mention that Barry Bonds hit a record 762 homeruns in his MLB career and he also holds the MLB record for most home runs in a season with 73.

But… as we found out after those records were broken, Bond’s extraordinary statistics were not because of practice, a new batting stance, maturity, or other organic factors. It was his use of steroids. The same steroids that allowed Bonds to get stronger, heal quicker, and produce Hall of Fame statistics will also take a toll on his health in the years ahead.  

Turn on CNBC or Bloomberg News, and you will inevitably hear the hosts and interviewees rave on and on about the booming markets, low unemployment, and the record economic expansion. To that, we say Yeah… As in the Barry Bonds story, there is also a “But…” that tells the whole story.

As we will discuss, the economy is not all roses when one considers the massive amount of monetary steroids stimulating growth. Further, as Bonds too will likely find out at some point in his future, there will be consequences for these performance-enhancing policies.

Wicksell’s Wisdom

Before a discussion of the abnormal fiscal and monetary policies responsible for surging financial asset prices and the record-long economic expansion, it is important to impart the wisdom of Knut Wicksell and a few paragraphs from a prior article we published entitled Wicksell’s Elegant Model.

“According to Wicksell, when the market rate (of interest) is below the natural rate, there is an incentive to borrow and reinvest in an economy at the higher natural rate. This normally leads to an economic boom until demand drives up the market rate and eventually chokes off demand. When the market rate exceeds the natural rate, borrowing slows along with economic activity eventually leading to a recession, and the market rate again falls back below the natural rate. Wicksell viewed the divergences between the natural rate and the market rate as the mechanism by which the economic cycle is determined. If a divergence between the natural rate and the market rate is abnormally sustained, it causes a severe misallocation of capital.

Per Wicksell, optimal policy should aim at keeping the natural rate and the market rate as closely aligned as possible to prevent misallocation. But when short-term market rates are below the natural rate, intelligent investors respond appropriately. They borrow heavily at the low rate and buy existing assets with somewhat predictable returns and shorter time horizons. Financial assets skyrocket in value while long-term, cash-flow driven investments with riskier prospects languish. The bottom line: existing assets rise in value but few new assets are added to the capital stock, which is decidedly bad for productivity and the structural growth of the economy.

Essentially, Wicksell warns that when interest rates are lower than they should be, speculation in financial assets is spurred and investment into the real economy suffers. The result is a boom in financial asset prices at the expense of future economic activity. Sound familiar? 

But… Monetary Policy

The Fed’s primary tool to manage economic growth and inflation is the Fed Funds rate. Fed Funds is the rate of interest that banks charge each other to borrow on an overnight basis. As the graph below shows, the Fed Funds rate has been pinned at least 2% below the rate of economic growth since the financial crisis. Such a low relative rate spanning such a long period is simply unprecedented, and in the words of Wicksell not “optimal policy.” 

Until the financial crisis, managing the Fed Funds rate was the sole tool for setting monetary policy. As such, it was easy to assess how much, if any, stimulus the Fed was providing at any point in time. The advent of Quantitative Easing (QE) made this task less transparent at the same time the Fed was telling us they wanted to be more transparent.  

Between 2008 and 2014, through three installations of QE, the Fed bought nearly $3.2 trillion of government, mortgage-backed, and agency securities in exchange for excess banking reserves. These excess reserves allowed banks to extend more loans than would be otherwise possible. In doing so, not only was economic activity generated, but the money supply rose which had a positive effect on the economy and financial markets.

Trying to quantifying the amount of stimulus offered by QE is not easy. However, in 2011, Fed Chairman Bernanke provided a simple rule in Congressional testimony to allow us to transform a dollar amount of QE into an interest rate equivalent. Bernanke suggested that every additional $6.6 to $10 billion of excess reserves, the byproduct of QE, has the effect of lowering interest rates by 0.01%. Therefore, every trillion dollars’ worth of new excess reserves is equivalent to lowering interest rates by 1.00% to 1.50% in Bernanke’s opinion. In the ensuing discussion, we use Bernanke’s more conservative estimate of $10 billion to produce a .01% decline in interest rates.

The graph below aggregates the two forms of monetary stimulus (Fed Funds and QE) to gauge how much effective interest rates are below the rate of economic growth. The blue area uses the Fed Funds – GDP data from the first graph. The orange area representing QE is based on Bernanke’s formula. 

Since the financial crisis, the Fed has effectively kept interest rates 5.11% below the rate of economic growth on average. Looking back in time, one can see that the current policy prescription is vastly different from the prior three recessions and ensuing expansions. Following the three recessions before the financial crisis, the Fed kept interest rates lower than the GDP rate to help foster recovery. The stimulus was limited in duration and removed entirely during the expansion. Before comparing these periods to the current expansion, it is worth noting that the amount of stimulus increased during each expansion. This is a function of the growth of debt in the economy beyond the economy’s growth rate and the increasing reliance on debt to generate economic growth. 

The current expansion is being promoted by significantly more stimulus and at much more consistent levels. Effectively the Fed is keeping rates 5.11% below normal, which is about five times the stimulus applied to the average of the prior three recessions. 

Simply the Fed has gone from periodic use of stimulus to heal the economy following recessions to a constant intravenous drip of stimulus to support the economy.

Moar

Starting in late 2015, the Fed tried to wean the economy from the stimulus. Between December of 2015 and December of 2018, the Fed increased the Fed Funds rates by 2.50%. They stepped up those efforts in 2018 as they also reduced the size of their balance sheet (via Quantitative Tightening, “QT”) from $4.4 trillion to $3.7 trillion.

The Fed hoped the economic patient was finally healing from the crisis and they could remove the exorbitant amount of stimulus applied to the economy and the markets. What they discovered is their imprudent policies of the post-crisis era made the patient hopelessly addicted to monetary drugs.

Beginning in July 2019, the Fed cut the target for the Fed Funds rate three times by a cumulative 0.75%. A month after the first rate cut they abruptly halted QT and started increasing their balance sheet through a series of repo operations and QE. Since then, the Fed’s balance sheet has reversed much of the QT related decrease and is growing at a pace that rivals what we saw immediately following the crisis. It is now up almost a half a trillion dollars from the lows and only $200 billion from the high watermark. The Fed is scheduled to add $60 billion more per month to its balance sheet through April. Even more may be added if repo operations expand.

The economy was slowing, and markets were turbulent in late 2018. Despite the massive stimulus still in place, the removal of a relatively small amount of stimulus proved too volatility-inducing for the Fed and the markets to bear.

Summary

Wicksell warned that lower than normal rates lead to speculation in financial assets and less investment into the real economy. Is it any wonder that risk assets have zoomed higher over the last five years despite tepid economic growth and flat corporate earnings (NIPA data Bureau of Economic Analysis -BEA)? 

When someone tells you the economy is doing fine, remind them that Barry Bonds was a very good player but the statistics don’t tell the whole story.

To provide further context on the extremity of monetary policy in America and around the world, we present an incredible graph courtesy of Bianco Research. The graph shows the Bank of England’s balance sheet as a percentage of GDP since 1700. If we focus on the past 100 years, notice the only period comparable to today was during World War II. England was in a life or death battle at the time. What is the rationalization today? Central banker inconvenience?

While most major countries cannot produce similar data going back that far, they have all experienced the same unprecedented surge in their central bank’s balance sheet.

Assuming today’s environment is normal without considering the but…. is a big mistake. And like Barry Bonds, who will never know when the consequences of his actions will bring regret, neither do the central bankers or the markets. 

The Wisdom of Peter Fisher

“In recent years, numerous major central banks announced objectives of achieving more rapid rates of inflation as strategies for fostering higher standards of living. All of them have failed to achieve their objectives.” – Jerry Jordan, former Cleveland Federal Reserve Bank President

In March 2017, former Treasury and Federal Reserve (Fed) official, Peter R. Fisher, delivered a speech at the Grant’s Interest Rate Observer Spring Conference entitled Undoing Extraordinary Monetary Policy. It is one of the most insightful and compelling assessments of the Fed’s post-financial crisis policy actions available.

Now a professor at the Tuck School of Business at Dartmouth, Fisher is a true insider with experience in the government and private sector that affords him unique insight. Given the recent policy “pivot” by Chairman Powell and all members of the Fed, Fisher’s comments from two years ago take on fresh relevance worth revisiting.

In the past, when Fed leadership discussed normalizing the Fed’s post-crisis policy actions, they exuded confidence that it can and will be done smoothly and without any implications for the economy or markets. Specifically, in a Washington Post article from 2010, Bernanke stated, “We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.” More recently, Janet Yellen and others have echoed those sentiments. Current Fed Chairman Jerome Powell, tasked with normalizing policy, appears to be finding out differently.

Define “Normal”

Taking a step back, there are important issues at stake if the Fed truly wants to unshackle the market economy from the influences of extreme monetary policy and the harm it may be causing. To normalize policy, the Fed first needs to explicitly define “normal.”

For instance:

  • The Fed should take steps to raise interest rates to what is considered “normal” levels. Normal can be characterized as a Federal Funds target rate in line with the average of the past 30 years or it might be a level that reflects sufficient “dry powder” were the Fed to need that policy tool in a future economic slowdown.
  • The Fed should reduce the size of their balance sheet. In this case, normal under reasonable logic would be the size of the balance sheet before the financial crisis either in absolute terms or as a percentage of nominal gross domestic production (GDP). Despite some reductions, it is not close on either count.

The Fed consistently feeds investors’ guessing games about what they deem appropriate. There appears to be little rigor, debate, or transparency about the substance of those decisions. Neither Ben Bernanke nor Janet Yellen offered details about how they would accurately characterize “normal” in either context. The reason for this seems obvious enough. If they were to establish reasonable parameters that defined normal levels in either case, they would be held accountable for differences from their prescribed benchmarks. It might force them to take actions that, while productive and proper in the long-run, may be disruptive to the financial markets in the short run. How inconvenient.

In most instances, normal is defined as something that conforms to a standard or that which has been common under historical experience. Begin by looking at the Fed Funds target rate. A Fed Funds rate of 0.0% for seven years is not normal, nor is the current rate range of 2.25-2.50%.

As illustrated in the chart below, in each of the past three recessions dating back to 1989, the Fed cut the fed funds rate by an average of 5.83%. In that context, and now resting at less than half the average historical pre-recession level, a Fed Funds rate of 2.25-2.50% is clearly abnormal and of greater concern, insufficient to combat a downturn.

Interest rates should mimic the structural growth rate of the economy. As we have illustrated in prior analysis and articles, particularly Wicksell’s Elegant Model, using a 7-year cycle for economic growth reflective of historical expansions, that time-frame should offer a reasonable proxy for “structural” economic growth. The issue of greater concern is that, contrary to the statement above, structural growth appears to be imitating the level of interest rates meaning the more the Fed suppresses interest rates, the more growth languishes.

Next, let’s look at the Fed balance sheet. Quantitative tightening began in late 2017 gradually increasing as the Fed allowed their securities bought during QE to mature without replacing them. As shown in the blue shaded area in the chart below, QT reduced the Fed balance sheet by about $500 billion, but it remains absurdly high at nearly $4.0 trillion. As a percentage of GDP, it has dropped from a peak of 25.3% to 19%. Before the point at which QE was initiated in September 2008, the size of the Fed balance sheet was roughly $900 billion or 6% of nominal GDP and was in a tight range around that level for decades. Now, with the Fed halting any further reductions in the balance sheet, are we to assume 20% of GDP to be a normal level? If so, what is the basis for that conclusion?

The bottom line: simple analysis, straight-forward logic, and common sense dictate that monetary policy remains abnormal.

Fisher helps us understand why the Fed is so hesitant to normalize policy, despite their outward confidence in being able to do so.

Second-Order Effects

As Fisher stated in his remarks at the conference, The challenge of normalizing policy will be to undo bad habits that have developed in how monetary policy is explained and understood.” This is a powerfully important statement highlighting second-order effects. He continues, “…the Fed will have to walk back from their early assurances that the “exit would be easy.” Prophetic indeed.

The “easy” part of getting rates and the balance sheet back to “normal” is now proving to be not so easy. What the Fed did not account for when they unleashed unprecedented policy was the habits and behaviors among governments, corporations, households, and investors. Modifying these behaviors will come at a debilitating cost.

Think of it like this: Nobody starts smoking cigarettes with a goal of smoking two packs a day for 30 years, but once introduced, it is difficult to stop. Furthermore, trying to stop smoking can be very painful and expensive. NOT stopping is medically and scientifically proven to be even more so.

Fisher goes on to explain in real-world terms how two households are impacted in an environment of extraordinary policy actions. One household possesses savings; the other does not. Consider their traditional liabilities such as mortgage and auto loans, “but also their future consumption expenditures, their liability to feed and clothe themselves in the future.” The family with savings may feel wealthier from gains in their invested savings and retirement accounts as a result of extraordinary policies pushing financial markets higher, but they also must endure an increase in the cost of living. In the final analysis, they end up where they started. “They may… perceive a wealth effect but, ultimately, there is only a wealth illusion.”

As for the family without savings, they had no investments to go up in value, so there is no wealth effect. This means that their cost of living rose and, wages largely stagnant, it occurred without any form of a commensurate rise in income. That can only mean their standard of living dropped. As Fisher states, given extraordinary policy imposed, “There was no wealth effect, not even a wealth illusion, just a cruel hoax.” He further adds, “…the next time you hear that the net-wealth of American households is at an all-time high, do spend a minute thinking about the present value of the unrecorded future consumption expenditures, particularly of households with no savings.”

What is remarkable about Fisher’s analysis is contrasting it with the statements of Fed officials who say they are acting in the best interest of all U.S. citizens. Quoting from George Orwell’s Animal Farm, “All animals are equal, but some animals are more equal than others.”

A man can easily drown crossing a stream that is on average 3 feet deep. Household wealth as a macro measure of monetary policy success in a period when wealth inequality is at such extremes perfectly illustrates this imperfection. As Fisher states, “Out of both humility and self-preservation, let’s hope the Fed finds a way to stop targeting the level of wealth.”

Linear Extrapolation

Fisher also addresses the issue of Fed forward guidance stating, “Implicit in forward guidance…is the idea that dampening short-term market uncertainty and volatility is a good thing. But removing uncertainty from our capital markets is not, in my view, an unambiguous blessing.”

Forward guidance, whereby the Fed provides expectations about future policy, targets an optimal level of volatility without being clear about what “optimal” means. How does the Fed know what is optimal? As we have stated before, a market made up of millions of buyers and sellers is a much better arbiter of prices, value, and the resulting volatility than is the small group of unelected officials at the Fed. Yet, they do indeed falsely portray an understanding of “optimal” by managing the prices of interest rates but theirs is a guess no better than yours or mine. Based upon their economic track record, we would argue their guess is far worse.

Fisher goes on to reference John Maynard Keynes on the subject of extrapolative expectations which is commonly used as a basis for asset pricing. Referring to it as the “conventional valuation” in his book The General Theory of Employment, Interest and Money, Keynes said this reflects investors’ assumptions “that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change.” Connecting those dots, Fisher states that “forward guidance is the process through which the Fed – through its more explicit influence on the expected rate of interest – becomes the much more explicit owner of the “conventional valuation” of asset prices… the Fed now has a heightened responsibility and sensitivity to asset pricing.

That conclusion is critically important and clarifies the behavior we see coming out of the Eccles Building. In becoming the “explicit owner” of valuations in the stock market, the Fed now must adhere to a pattern of decisions and actions that will ultimately support the prices of risky assets under all circumstances. Far from rigorous scrutiny of doubts and assumptions, the Fed fails in every way to apply the scientific method of analyzing their actions before and after they take them. So desperate are they to manage the expectations of the public, their current posture leaves no latitude for uncertainty. As Fisher further points out, the last time we saw evidence of a similar stance was in 2007 when the Fed rejected the possibility of a nation-wide decline in house prices.

Summary

Fisher fittingly sums up by restating the point he made at the beginning:

“…the Fed and other central banks appear to have avoided being candid about the uncertainty (of extraordinary monetary policies) in order to maintain their credibility. But this is backwards. They cannot regain their credibility unless they are candid about the uncertainty and how they confront it.”

The power of Fisher’s perspectives is in his candor. Now at a time when the Fed is proving him correct on every count, it is worthwhile to refresh our memories. We would encourage investors to read the transcript in full. Given the clarity of the insights he shares, summarized here, their importance cannot be overstated.

Undoing Extraordinary Monetary Policy